Fiscal Imbalance: Reply to Jim Hamilton

Eventually you run into the logistical constraint that there simply aren’t enough funds in the world to buy that much debt. As soon as lenders recognize that’s where the process is headed, the government is going to find it suddenly much more difficult to borrow the necessary new sums.

To prevent that from happening, over the long haul any government is forced to run a primary budget surplus, meaning that tax receipts exceed expenditures other than interest costs, in order to be able to use some of that primary surplus to make interest payments. The higher the debt load, the higher the steady-state primary surplus needs to be.

The logistical constraint technically only necessarily binds if the interest rate on Sovereign debt exceeds the nominal growth rate of the entire world denominated in the Sovereign’s currency.

However, I think Jim’s basic point can be seen if we just think about what it would take to keep Sovereign debt from rising to an arbitrarily high fraction of GDP for the country itself.

In that case typically what we are going to need is not primary surplus but primary balance, more or less. That is because the opportunity cost of funds is almost necessarily going to be lower than the nominal growth rate of the economy.

If not then using an arbitrarily small amount of seed funding one could eventually come to take over the entire country simply by making risk-free loans. Were this the case its likely some financial institution would attempt to do this and in the process drive down the opportunity cost.

Jim continues

According to ECB data, Greek government debt was already 120% of GDP in 2008. The primary budget deficit was over 10% of GDP in 2009 and almost 5% in 2010. That plus the rapidly increasing interest rate facing Greece pushed their debt to 156% of GDP for 2010

And from there it’s hard to tell a story with a happy ending. Even if the Greeks defaulted 100% on the outstanding debt, moving the primary budget back to balance requires significant contractionary moves.

The primary balance constraint is long term. If Greece had an unlimited source of liquidity then there is no particular reason that one would assume from this information that there was no happy ending or indeed any need to default.

Now it might be the case that the Greeks are simply not interested in making good on these loans or ever achieving primary balance.

Or in, theory it could also be the case that the Eurosystem or whatever system the Greek currency operates in cannot extract enough resources from the banking sector to cover a five percent primary balance. This, however, seems unlikely.

The most likely case is that with a Lender of Last Resort the only pressing question is whether Greece wants to make these payments.

Jim moves on to Italy

A year ago, the Italian government was able to issue 10-year bonds with an interest cost below 3.8%. Some might have argued that those low rates were a signal from the market that there was not much chance of Italy following Greece down the drain. At a visit to UCSD a few weeks ago, University of Maryland Professor Carmen Reinhart was asked whether that’s a correct inference to draw from a low government borrowing cost. Emphatically not, she said: “Yes, yields are low– until they’re not.” Historically, the changes can come pretty quickly, as the Italians discovered last week.

I think this is the wrong way to look at it, though I understand why debtors might think this way.

However, from the point of view of a creditor or investor this is doesn’t make sense. You are not in the business of losing money by buying Italian bonds.

If Italian bonds are trading at below 3.8 this is a fairly strong indication that a default is not imminent based on current circumstances. The problem is that without a Lender of Last Resort, its (almost) always possible for Italy to face a run.

If for whatever reason people come to believe that other folks will not buy Italian debt, then that means that Italy will not be able to roll over its debt and will default. Thus you should not buy Italian debt.

If Italy does not need to borrow to finance or roll over the debt or if the debt is so small that should it crash in price some player – possibly even the Italian government – could come in a buy the lot, then this cannot happen.

However, if the debt is large enough then this can happen. Thus the reason yields explode is because the probability of default is a function of the yield and the yield is a function of the probability of default. A self-reinforcing cycle can be entered into where the probability of default races off to one and the yield races off to infinity.

This is crisis or a run.

This isn’t, however, a sign of the interest rate mispricing risk, it’s a sign that risk can change rapidly because it is not moored to anything fundamental. You are always playing this game in the credit markets unless there is a Lender of Last Resort.

Jim ends with

And this is the heart of the problem. Who takes the losses, and if they fall, who do they then bring down in turn? If you’re somebody with funds to lend and don’t know the answer, in response to these fears what you do is cut back all kinds of lending. If that sounds familiar, it should, because it’s exactly this kind of ricocheting financial uncertainty that brought down the world economy in the fall of 2008.

This I think is exactly right. Unless someone steps in as Lender of Last Resort it is always possible to have a repeat of 2008 or worse.

A point that I try to make is that unless at some point some institution with coercive power is willing to backstop this entire process there is virtually no limit to how bad it can get.

It is entirely possible for the Global Capitalist System to come to an end. Indeed, one day it certainly will. Lets just try to not have that be tomorrow.